That fateful day back in September 2022 when the then prime minister Liz Truss and her chancellor Kwasi Kwarteng tried to push through £45bn of unfunded tax cuts created a series of catastrophic and unintended events.
The speed and the depth of the devastation was unprecedented and, in no particular order, Kwarteng was hauled home early from an IMF meeting in Washington and promptly sacked, the pound fell to its lowest ever level against the dollar, the Bank of England was backed into an emergency bond-buying programme, and Truss was forced to resign after just 45 days in office, making her the shortest-serving prime minister in British history.
The period was punctuated by one high-profile disaster after another but for a previously sleepy and lesser-known corner of financial markets it also caused no end of problems.
Indeed, almost overnight liability-driven investment (LDI), leaned on by corporate defined benefit (DB) pension schemes to help with asset-liability matching, went from a topic only covered in the pension and investment press to one that began making front page national news.
Kwarteng’s mooted tax cuts, which included scrapping the top 45% rate of income tax, sent shockwaves through investment markets, resulting in plummeting gilt prices that pushed debt-fuelled LDI strategies to near-breaking point.
Amin Rajan, chief executive of Create Research, an asset management consultancy, says: “The mini-Budget was heroic in its naivety and catastrophic in its impact. At a stroke, it trashed national, pension and mortgage finances.”
The dust has since settled but, almost exactly two years on, market participants remain divided over whether the underlying issues responsible for the difficulties have been fixed, with some adamant that significant hazards continue to lurk beneath the surface.
One thing they do agree on, however, is that the size, strength and trust in the LDI market will never be the same again.
Keeping it complex
So what exactly happened?
In short, after gilt yields soared on the back of the mini-Budget, pension funds scrambled to sell assets, particularly UK government bonds, in order to meet so-called margin calls on their LDI hedges.
Pension fund trustees fell over themselves to sell gilts in order to meet these collateral obligations, driving down the value of the bonds even further and creating what is dubbed a ‘doom spiral’.
Without the Bank of England stepping in and propping up the market by buying bonds on an industrial scale the sell-off could have been fatal for great swathes of the country’s defined benefit schemes.
Market experts say DB pension schemes were taken to the brink by their naivety, but that greed also played a part.
Indeed, when LDI was originally conceived more than 20 years ago the idea was to simply help pension schemes better match their assets and liabilities.
As time progressed, however, strategies became more complex, with healthy doses of leverage added in to try and boost returns amid what was then a persistently low interest-rate environment.
The upshot is that what was once a simple and straightforward investment idea morphed into something that became increasingly harder for trustees to understand – so much so that the eventual crisis that took hold in 2022 came as a complete surprise for many, with little comprehension among pension funds as to how they got there.
John Ralfe, an independent pensions consultant, who was head of corporate finance at Boots when it switched from equities to bonds in 2000, says: “I would say that 99% of trustees had no clue what they were doing at the time and most investment consultants didn’t know any better either.
The leveraged LDI strategies being used when the crisis kicked in were far more complex and risky than people realised and were being touted. “At some point in the early 2000s LDI went from something that was simple to something that was anything but.”
Leverage, he adds, was layered on top of strategies to eke out re- turns at the same time as matching liabilities. Greed took over.
“Trustees were told back then that using leverage was the way to square the circle,” he says. “People thought they could get something for nothing and that seemed to be the case as interest rates came down. But, when they rose sharply after the mini-Budget, problems quickly set in. The approach was marked by wilful ignorance.”
Rajan agrees: “The asset re-sale forced by margin calls was unprecedented in the pension world. Once again, the episode showed there are no sure- re and risk-free strategies in investing.”
Part of the problem, Ralfe continues, is the preponderance among investment consultants and asset managers to peddle convoluted financial instruments that make their high fees easier to defend.
“The market has been making hay from leveraged LDI strategies for a long time now. And the big investment consultants are especially to blame as they get paid for complexity,” he says. “It seems to me that there is always some new sophisticated product that they are pushing. There is a lot more money to be made by keeping things complex rather than simple.”
Getting jittery
In the immediate aftermath of the 2022 crisis, however, that ability to make money collapsed, at least in the short term. As jitters set in, investors pulled billions of pounds from the biggest investment houses operating in this area in the days, weeks and months after gilt prices nosedived.
British fund manager Schroders lost more than £20bn of assets from the unit that housed its LDI business during the third quarter of that year, while investors pulled £19.7bn out of Legal & General Investment Management’s (LGIM) UK DB Solutions business, the firm’s liability-driven investment arm, during the first half of 2023.
Schroders and LGIM, alongside Insight Investment and Blackrock, are among a concentrated group of dominant players in the LDI market. LGIM said at the time: “Our overall defined benefit revenue decreased as interest-rate rises caused assets under management to reduce and as clients sold higher fee-generating investments to meet collateral requests.”
It added that the “extreme volatility” in the UK gilt market following the mini-Budget “highlighted the need for technical changes to ensure the smooth functioning of LDI and the government’s financing of its debt”.
Endgame
And it is not expected that those lost assets will come back at the rate the market once enjoyed. Not just because of what happened in 2022, but due to the enormous volume of hedging that has already taken place.
Danielle Markham, head of LDI at Barnett Waddingham, an independent pension and investment consultancy, told portfolio institutional: “It is unlikely that the LDI market will ever return to its previous value in terms of liabilities hedged. During 2022 the value of UK DB liabilities fell significantly by 30% to 40% for many schemes [due to interest-rate movements] – and this means that the value of liabilities to hedge has also fallen sharply.”
She adds that DB schemes have also reached a point where the vast majority of their liabilities are hedged, making it “inevitable that the market would stop growing at some point. As such it is unlikely that we will see a sudden increase in growth from here”.
Evan Guppy, head of LDI at the Pension Protection Fund, the UK’s £33bn lifeboat fund, agrees. “Our data shows that by April 2022, DB schemes had invested nearly 80% of assets in hedging instruments like bonds and annuities, up from around 45% 10 years previously.
“The big change in investment strategy towards liability hedging assets has already happened: meaning there simply isn’t the same scale of unhedged liabilities left to manage. An additional and related headwind for LDI is that more schemes are now able to achieve a pension buy-out, and we are seeing an increasing number of schemes reaching their endgame with insurers.”
In May, for example, the Nortel Networks UK Pension Plan completed its third and final buyout with Legal & General, with £2.5bn of the plan’s liabilities now insured with the group. It is one of many such deals to be finalised.
Guppy adds: “All this means there is less new hedging needed by DB pension schemes while some of the existing hedging is being transferred to insurers.”
A lack of focus
That may well be true, but the fact the LDI market had already grown so big is part of the problem, as that growth went largely unchecked. Getting a handle on the size of the market and just how many pension funds were using leveraged LDI was not clear and, according to a report from the Work and Pensions Committee written in the wake of the crisis, this was a key contributor to the mess.
The report also flagged that the Bank of England had already previously raised concerns about the rise of LDI but this had not been properly interrogated by the pensions watchdog, which the report referred to as a “missed opportunity to improve resilience”.
The report read: “After the Bank of England spotted the potential risks of LDI use in 2018, The Pensions Regulator conducted a survey but neglected to look at small pension funds, which were the cause of the instability because of the nature of their arrangements. There was also no system put in place to collect data on how LDI was used. It was not known that leverage grew, giving rise to systemic risk.”
The committee called for a more systematic collection of data and for regulators to work together to analyse those findings to spot emerging risks. It also said the Department for Work and Pensions should consider whether the use of LDI should be restricted while the process of improving standards of scheme governance takes place.
Sir Stephen Timms MP said at the time: “The turbulence around the mini-Budget exposed a lax approach to regulation. Despite the dangers of the use of LDI being identified more than five years ago, there was a lack of focus from the regulator and inadequate data. The use of leverage by DB pension funds grew, giving rise to systemic risk in a way that was not visible to regulators until the crisis hit.
“Although the speed and scale of the rise in gilt yields was unprecedented, the consequences for DB pension funds should have been foreseen and the regulator should not have been blindsided.”
In fairness to The Pensions Regulator, it has done much to try and improve the resilience of LDI funds since the crisis, including increasing operational buffers to manage day-to-day volatility and working with overseas regulators to improve understanding of the risks, but much of the problem has been resolved by the fact that pension liabilities have decreased, meaning the need for LDI strategies is now not what it was.
Ralfe says in closing: “People were flying by the seats of their pants at the time. But has anything changed over the last two years? I’m not so sure.”
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